Executive pay as a function of luck

Realisable executive remuneration using unhurdled share options is often a matter of luck.

The classic example is that of US oil company CEOs whose remuneration (mainly comprised of stock options) increased with the price of oil (see HERE).

This has been shown to hold for other factors that are both outside the control of the executive, and observable to the boards who grant remuneration, yet rarely adjust it for these factors. Option grants that do not have exercise prices indexed for industry returns are one example. Another is LTIs contingent on total shareholder return (TSR) relative to general market peer groups rather than an industry group, or a method to control for cross industry betas (for example, see HERE).

A recent paper by Professor Moshe Levy attempts to estimate the magnitude of the pay-for-luck component in US option-based remuneration. How much of the “pay-for-performance” remuneration is actually paid for luck?

The answer depends on the ratio between the manager’s talent, defined as her ability to increase the firm’s average return, and the inherent “noise” in the stock’s returns, as measured by the standard deviation of returns.

The author develops an analytical expression for the proportion of option-based remuneration that constitutes pay-for-luck as a function of the ratio. The research shows that this proportion grows very quickly with this ratio. The extent may be a surprise. For the empirically-estimated parameters, the pay-for-luck component exceeds 90% of the remuneration.

This result appears robust, and stems from the fundamental fact that chance plays a dominant role in determining firm performance.

The large pay-for-luck component implies that, perhaps in contrast to widespread belief, US style option-based remuneration that does not have vesting contingent on specific performance requirements does not constitute a strong motivational force for the manager.

Indeed, the research shows that an option’s motivational force is inversely related to its pay-for-luck component.

For example, a manager with talent T=2%, i.e. an executive who can increase the firm’s average annual return by 2% if she exerts effort and manifests her talent. Alternatively, the executive can refrain from exerting effort to manifest her talent, in which case the firm’s average return will be the same as the industry average. By how much does the executive’s expected remuneration increase as a result of her effort? The research shows that for standard non-indexed at-the-money options and realistic parameters the increase is only about 12% relative to the case of exerting no effort.

This does not seem to constitute a very strong motivational force.

Other factors, such as ego, self-fulfillment, the desire not to be perceived as lazy, or just the motivation to retain employment (in behavioral economics, known as satisficing – see HERE) may be much more effective motivating forces.

The research suggests that indexing the option to the market (or industry, or both) and setting its strike price 50% higher than the granting-day price almost doubles the option’s motivational force.

This paper shows that the option remuneration that is not subject to specific performance conditions for vesting is far from optimal, given its pay-for-luck component is in the ballpark of 90%, and its motivational power is low.

While we acknowledge that startups with limited cash flow, appropriately use options in lieu of cash salary, based on this research, it is hard to justify granting options at-the-money with no specific performance contingent requirement for established companies.

See the recent paper HERE

© Guerdon Associates 2024
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